Erstwhile mechanical engineer and Forbes Executive Editor, with MBA from NYU. In 15 years at Forbes I covered large corporations, money managers and self-made wealth builders---and the myriad trials they all face. Joined the tech-startup ranks in 2014 as co-founder and CFO of Eyes/Only, a luxury-experience portal for high-net-worth individuals. If the mood strikes (and especially if you have a tasty-tequila rec), please send your thoughts to brett@eyeson.ly.

Led by billionaire visionary Larry Ellison, Oracle has a vast customer base, well-established distribution channels, and a small island of cash and marketable securities ($33 billion) on its balance sheet. At a recent $34, the software giant’s shares trade at a relatively modest 16 times its trailing-12-month earnings, versus 19.2 for the S&P 500 and 18.5 for the NASDAQ 100. Meanwhile the Federal Reserve continues to coax stock prices to lunar levels—and when the market moves, Oracle tends to move faster in the same direction.

Oracle (and legacy rival SAPSAP) built an empire selling so-called perpetual licenses—that is, customers bought the software once and used it indefinitely on their premises. In the brave era of cloud computing, software is sold on a subscription basis and delivered on-demand over the Web. That plug-and-play model curbs outlays on servers, storage, networking equipment, on-site IT staff and juicy maintenance contracts—precious savings for small-and mid-sized companies looking to do more with less. That’s why (along with the law of large numbers) annual revenues posted by the top 10 public-cloud companies (including poster child Saleforce.com) grew an average 37% in 2012, versus 2% for the top 10 system integrators (such as IBM, Computer Services and Accenture) and the top eight packaged-software companies (including Oracle, SAP and Microsoft), according to Baird.

This is an old story—cloud computing has been around in some fashion since the late ’90s, though it’s gained serious steam lately—and Ellison hasn’t exactly been sitting still. In the last few years Oracle has developed, acquired and loudly touted its own cloud-flavored services while trying to preserve its traditional licensing business. This transition (documented in real-time by hordes of tech scribes) will unfold over many quarters, and Oracle may ultimately emerge stronger than ever. But count on plenty of stomach-churning turbulence along the way.

Just two precedents: Ariba (bought by SAP in 2012) and Concur Technologies both successfully transitioned from packaged software to an on-demand model—and both stocks were severely punished in the interim.

Ariba, which made purchase-automation software, began its shift in May 2004 and launched its first two Web offerings in October 2005. During that stretch, its $13 shares sank by 40%, while the S&P 500 advanced 9%. (SAP paid $45 a share for Ariba in May 2012.)

Concur Technologies, which makes expense-management applications, began its transition to the cloud in early 1999, in the heart of the dotcom boom. By the second half of the year, license revenues were flagging. When the company failed to meet analysts’ estimates in the third and fourth quarters (it missed its 4Q revenue target by 30%), its $38 shares collapsed 80% in six months, while the S&P 500 fell just 5%. (Concur traded at a recent $80 a share.)

At Oracle, software accounts for 75% of the company’s revenue; hardware (servers) and services make up the rest. Two-thirds of those software-related sales come from license updates and product support—streams that Web-based software likely will choke over time. The hardware segment, shrinking since 2011, may suffer sooner: For the third quarter ended in March, trailing 9-month sales were down 17%.

The picture gets muddier. As the migration to the cloud accelerates—and it is accelerating—Oracle and other legacy firms will face three less-understood operational challenges that could haunt investors, at least in the near term:

Sales Management

How software is delivered profoundly changes the way it is sold, in terms of dealing with customers and managing salespeople.

Selling perpetual software licenses is very transactional—once the sale is made, the work is more or less done, regardless of how customers ultimately use the product. Selling subscriptions requires deeper, ongoing relationships with customers to understand their needs and earn renewal business. Easy for new cloud-only vendors—that’s how they’ve always done it—but harder perhaps for legacy firms making the transition.

Compensation is another challenge. Large, up-front commissions on perpetual-license sales are attractive, but that’s not where the business is going. For top salespeople, the better money—in cash compensation and equity upside—is increasingly in the cloud. (One sizzling player, Workday, which delivers human-resource-management software via the Web, recently traded hands at 36 times revenues.) Newer cloud-based vendors also tend to be less bureaucratic than legacy IT firms, another draw for top talent.

What it means: Pressure on legacy firms’ top lines.

What to watch: Beware defections of top sales talent to the cloud.

Product Pricing

Selling perpetual licenses is all about hitting revenue targets, whatever that takes. (Hence the mad scramble to close deals toward the end of each quarter.) Selling subscriptions requires more pricing discipline: To maintain profit margins, vendors have to understand what customers are truly willing to pay. Miss on the low side and they may not accept a price hike later on.

What it means: Legacy vendors will struggle with new pricing models, which could crimp revenue growth and operating margins.

What to watch: Track (if you can) the relationship between pricing and customer-renewal rates. A rising deferred-revenue balance is a good sign, but only if customers aren’t getting overly steep discounts.

Revenue Recognition

In the perpetual-license model, software companies book a majority of the purchase price up front and recognize maintenance fees over the next few years. In the subscription model, revenue is recognized ratably over the length of the contract. (The same holds on the expense side: Legacy vendors recognize sales commissions up front, while on-demand vendors spread them over the life of the contract.)

What it means: Lower reported revenue in the near term as legacy vendors reap fewer up-front perpetual-license fees. Such dips could spook the Street.

What to watch: Keep an eye on new accounting rules forcing companies to tightly match reported revenue and sales expenses. (For details, see the Revenue Recognition Exposure Draft, issued by the FASB and IASB.)

Oracle is a formidable competitor with a $162 billion market cap. But never forget: A skittish, overheated stock market can be cruel to companies—even stalwarts—in transition. When Oracle missed analysts’ revenue estimates last quarter, the shares promptly tanked 12%.

Oracle’s next earnings call is in mid-to-late June. You don’t need to be a cloud-computing expert to know it never hurts to prepare for rain.

Have a thoughtful investment thesis on the shift to cloud computing, or more broadly on investing during periods of great change? On the entrepreneurial/management side, have any advice for navigating periods of great change? Please comment on this post.

Post Your Comment

Post Your Reply

Forbes writers have the ability to call out member comments they find particularly interesting. Called-out comments are highlighted across the Forbes network. You'll be notified if your comment is called out.